About Austrian economics

By Lorenzo

I find Steve Horwitz, along with George Selgin (prominent advocate of free banking and supporter of a productivity norm [pdf] for monetary policy), the most accessible of contemporary Austrian school economists as they are both clear writers who seek to engage with those who are not of their school and are refreshingly free of the nastiness that so many Austrian school commentators seem prone to. (Little, if any, of what I have to say in the following applies to Selgin and some applies to general tendencies in Austrian commentary rather than Horwitz.)*

Horwitz has written a very useful paper on Hayek and Keynes’ different understandings of capital. Points that strike me reading the paper, and particularly Horwitz’s presentation of the Hayekian/Austrian concept of capital, include:

(1) The Austrian view of capital is over-impressed by differentiation, as when Horwitz writes:

What is central for the Austrian theory is that capital is not homogenous; capital goods are not perfect substitutes for one another. Any given good can only serve in a limited number of production plans, and it is not possible to create any given production plan out of any capital goods. Goods are not infinitely substitutable, and not all goods have the requisite complementarity necessary to be part of any particular production plan. This emphasis on the “heterogeneity” of capital distinguishes Austrian capital theory from many of its predecessors, especially those, most obviously Knight‘s “Crusonia plant” or Solow‘s “shmoo,” that viewed capital as a homogenous fund of resources from which equally useful “ladles” could be applied to any production process.

Yes, once resources are allocated to specific capital, they are difficult to shift to other uses. Nevertheless, the ongoing process of allocating resources to creating capital is important in its own right. Capital is not homogeneous (neither is labour ; something which seems to figure rather less in Austrian analysis) but there is enough flow of resources in an economy that heterogeneity is not all there is to grapple with.

(2) Thus, there is in the Austrian approach, a somewhat “frozen” view of capital: that it can be difficult to reallocate, does not make it impossible. As Horwitz notes later in the paper, the loss of value in capital no longer allocated to its original use measures how difficult but not impossible it is. Conversely, heterogeneity of labour would suggest that labour markets also have adjustment delays and constraints, which sits rather poorly with Austrian confidence in fully flexible wages if there were no regulatory interventions.

(3) At the same time, there is a perfectionist view of markets, that there is a “correct” arrangement of capital. As when Horwitz writes:

… the capital structure and the process of monetary calculation that drives it is the fundamental coordinating process of the market economy. Fitting those pieces together as correctly as possible, in response to knowledge and incentives produced by the pleasurable and unpleasureable beeps of profit and loss, is what ensures ongoing economic coordination and growth.

Yes, profit and loss direct resources to more valuable uses, but the notion of a single “correct” outcome glides over a whole lot of issues about incentives, constraints, information flows, etc. Yes, the “pieces” have to fit together, but they are constantly being created and replaced, with a fair bit of “good enough” going on because of various constraints, varied incentives, information asymmetries, etc.

(4) The emphasis on the role of money in economic calculation is somewhat one-sided, as when Horwitz writes:

What guides this process of plan formation, deconstruction, and reconstruction is monetary calculation. In a market economy where capital goods have money prices, those prices enable entrepreneurs to prospectively formulate budgets and retrospectively calculate profits and losses. Budgets based on those prices are what enable entrepreneurs to decide which capital goods will effectively serve as complements in an integrated production plan. After that plan has been executed, profits and losses signal owners of capital whether or not the plan was successful, which enables them to decide whether the uses of capital were, in fact, sufficiently complementary to continue. If not, then the money prices of other capital goods provide the information necessary to engage in another round of calculation and budgeting to see what sorts of capital goods might serve as substitutes for pieces of the failed plan.

Yes, the various “swap values” of money (for goods and services) matter, but what entrepreneurs are really interested in is expected income; that is, price x transactions. It is not that there is no concept of demand/expected income in the Austrian analysis, it is that, at crucial points in the argument, price is emphasized to the extent that transaction levels, and so income expectations, disappear from view. (David Beckworth has a nice post connecting collapsing transaction levels, and so income expectations, as reported by business survey respondents, with the economic downturn in the US; or, to put it another way, it’s the level of transactions, … .) Price is not a perfectly flexible lever; particularly given the different time scales between stages of production, to use Austrian language, and constraints in labour markets.

(5) Following on from (4), the fundamental role of money in an economy is to facilitate transactions, including across time. The typical Austrian emphasis on money-for-calculation, and presumption of state monopolies as over-suppliers of money, leads to an obsession with inflation and the risk of hyperinflation. (Hence my comment that an internet Austrian is someone who has predicted 10 of the last 0 bouts of hyperinflation.) As a matter of historical fact, deflation (and unexpected disinflation) can be much more destructive of economic activity than inflation. Both inflation and deflation interfere with money as a means of economic calculation, but deflation (and unexpected disinflation) also drives down income/economic activity, which makes it much more destructive. But the Austrian view of business cycles is so focused on finding reasons for busts in the previous booms (those money over-supplying central banks) that it, in effect, blames the effects of deflation on previous inflation. Yet inflation and deflation are equally monetary phenomena, one is not causally dominant over the other.

(6) The Austrian theory operates in terms of saving preferences, conceived as time preferences, as when Horwitz writes:

Hayek and the Austrians were working from a classical loanable funds theory of the interest rate. On this view, the interest rate was the price of time, emerging from the supply of loanable funds from savers and the demand for loanable funds by investors.

If interest rates are the price of time, where is risk? It is true that time preferences vary between people and periods of life. But so does risk aversion and assessments of risk. Shifts in risk assessments (and income expectations) seem generally a much more plausible reason for changes in interest rates (and asset prices generally) than some unexplained (what economists call ‘endogenous’) shift in time preference (which can be expected to be much more stable than risk assessments). Saying that risk assessments are subsumed into time preferences would be hand-waving to excuse the downplaying of risk assessments.

It is not that the Austrian picture denies risk, it is that, at a crucial point in the argument, the argument is mounted in terms of time preferences, rather than risk, which gives the prices-will-coordinate-so-well-there-can-be-no-general-glut-of-goods-and-services story more plausibility than it otherwise would have. Put things in terms of risk and then the possibility of a precipitous decline in spending which prices will not successfully compensate for becomes much more plausible. Particularly as sticky prices are typically a form of risk-management.

(7) Horwitz puts the Austrian business cycle theory on its best construction when he writes that Austrians:

look for explanations of recessions or “busts” by asking if the bust was preceded by a boom. A boom is not a necessary condition for a recession but it is sufficient, and Austrians argue that a preceding boom is the most frequent cause of a bust. Key to understanding that boom-bust cycle is how the capital structure gets distorted in the boom, which also helps to understand how Austrians view the bust.

Alas, there is no reliable correlation between the level of inflation in any boom and the scale of the subsequent bust. Despite claims to the contrary at the time, the 1920s was not particularly inflationary: certainly nowhere near enough to explain the depth of the 1930s crash. As George Selgin writes in his productivity norm essay (p.58):

Indeed, the relative inflation of the previous decade is only likely to have played a relatively minor part in explaining the length and severity of the depression, in contrast to its major role in causing the stock-market boom and crash.

Similarly, the contemporary Great Recession, the worst recession in the postwar era, has followed the least inflationary boom in the postwar era. There is simply no correlation between the level of preceding inflation and the level of the consequent bust. As noted above at (5), deflation is a monetary phenomenon in its own right.  But if state monetary monopolies fail in specific, predictable ways (propensity to oversupply money), the argument for their abolition is easier than if their failures are far more erratic (sometimes oversupplying, sometimes undersupplying, implying that sometimes they get it right, a habit it might be possible to expand; there still is an argument for free banking, but it becomes more grounded in general supply-and-demand arguments applied to money which sit much less well with Austrian business cycle theory).

(8) Following on from (7), there seems to be such a strong wish to see the market system as naturally self-correcting—or, more precisely, as strongly systematic: in economist-speak, strongly equilibrating—that flaws in the boom have to be invoked to explain the level of the bust. Yet why cannot the bust be a result of something that has little or nothing to do with the pre-existing boom? This being more plausible if shifts in risk assessments drive actions more than shifts in time preferences, as the former are likely to be much less stable than the latter and much more susceptible to shifts in information (and so expectations).

(9) This also gets back to the unbalanced focus on money-as-value-calculation as against money-as-transaction-facilitator. There is too much focus on the “price” story of money and not enough on the “supply and demand” story (that is, the level of transactions, so level of income story—income as measured by the medium in which existing obligations, notably debt, are set). For if the demand for money rises when the supply does not, transactions, and so income, will fall. (And there is nothing like heightened risk assessment and/or income pessimism to encourage folk to hang on to money, or use it to liquidate debt; particularly if they expect money to retain, or even increase, its “swap values”.) But, in keeping with the Austrian approach being overly systematic, there is too strong a presumption that a monopoly provider of money will oversupply. (Noting that monopoly providers in other markets are presumptively under-providers; even given that the supply of paper money, at a certain level of technology, is not cost-constrained makes applying normal monopoly theory problematic.)

(10) The overly systematic Austrian story, particularly the downplaying of the role of risk in action across time and risk management in constraining prices, lead naturally to being on the “no general glut” side of macroeconomics, as outlined in Brad DeLong’s nice post about macroeconomics. The downplaying of risk fits in with the over-systematising. (Risk being inherently “messy”, even somewhat chaotic.) This in turn naturally flows from the a priori analytical approach of the Austrian school.

(11) An unfortunate tendency from the last feature is that “internet Austrians” (though not Horwitz or Selgin) are often abusive, indifferent to evidence and discount experience. No contrary evidence is permitted, as it is all redefined so it is not contrary. (A technique I am familiar with from natural law analysis, where contrary evidence is just defined as perverse and so does not count: the conclusion gets to choose the ambit of its premises —what philosopher Anthony Flew called “the no true Scotsman” fallacy.) The analysis thus subsumes all evidence into its a priori analysis. (Again, anyone who has had to deal with the natural law “marriage is by definition between a man and a woman” assertion parading as an argument is familiar with the pattern.) The analysis is therefore so “self-evident” that only stupidity or malice is left to explain disagreement

Ironically, Catholic natural law philosopher Ed Feser has posted a critique of noted Austrian economist Murray Rothbard, and a response to an attempted defense thereof, that targets nicely the “I have the answers, because I can just deduce them” outlook that is a persistent feature of Austrian commentary and is not an impressive, persuasive or encouraging feature thereof. I was, at first, terribly excited by the “reasoning from first principles” at the beginning of Ludwig von Mises‘ magnum opus Human Action. Alas, experience and reflection since has made me much more sceptical about this sort of approach.

For example, the single most useful analytical tool developed in C20th economics was Ronald Coase’s identification of transaction costs. How did he do this? By asking a great question (why do firms exist?) and then finding the answer by asking people in business how they make the decision whether to produce in-house or buy on the open market. Using an analytical framework is not a matter of “looking for footnotes” because you already have the answers. It is a matter of intelligent engagement with reality so that part of what developing understanding means is the slow development of an appropriate analytical framework. In that sense, a good analytical framework represents, not merely a work in progress, but distilled continuing engagement with reality; as with Ronald Coase and transaction costs.

This is not an objection to analytical frameworks per se: far from it. The analytical frameworks of economics and of law provide powerful advantages in examining events. Not because they are deduced from first principles but because they have been built up by an interactive engagement with reality.

(12) The Austrian downplaying of risk and the unbalanced focus on money-as-price-calculation, as against the level of transactions, as well as the notion that there is a “correct” allocation of capital, leads to one of my pet dislikes, the concept of malinvestment. A concept I strongly disagree with, for reasons I explain here and here. There is not any useful general concept of malinvestment that is independent of the level of economic activity. Sure, businesses fail but they do so all the time, even in the height of booms, and this discovery process is much more about exploring boundaries of what is or is not profitable (boundaries which shift as the level of economic activity shifts) than displaying some inherent characteristic.

Yes, one can get inappropriate construction (e.g. empty housing estates in post-bust Ireland or various US cities) but they were the result of very specific forms of perverse incentives, not indicative of some general phenomenon, even in housing construction (even if you add in various complications).

Expectations about future income obviously will affect what people invest in, but a monetary authority that drives such expectations up is less dangerous than one that drives them down. (See previous comment about deflation and unexpected disinflation being worse than inflation.)

In conclusion
That I am critical of the Hayekian-Austrian view Horwitz is presenting does not mean accepting Keynes’s position. I agree with David Glasner, both were wrong on crucial points. Keynes’ “animal spirits” for example, is much more usefully thought of as how people frame (Knightian) uncertainty. And, while monetary policy can certainly be incompetent, it is never impotent.  Reviewing a recent book on the Hayek-Keynes debate, economist Tyler Cowen provides an excellent survey (pdf) of errors by Hayek and Keynes. (Though David Glasner demurs on Cowen’s characterization of what Scott Sumner is doing.)

In a monetary exchange economy, recessions (and depressions) are always and everywhere a monetary phenomenon but not, contra Austrian analysis, a particular pattern of monetary phenomena. For example, it was the deflationary policies of (pdf) the Federal Reserve and the Bank of France that caused the 1929-32 Depression not some mythic inflationary boom. Just as the European Central Bank has caused the current euro crisis and the Fed turned a financial crisis into a Great Recession: on all these occasions, the sin being the under-provision of money by monopoly providers, not its over-provision.

Steve Horwitz has written an admirably clear paper that has enabled me to identify and clarify disagreements with the Austrian school. Such clarity is especially useful for those of us using downloadable papers and blogs as an ongoing economics education. He is to be commended for his care and clarity in exposition. Especially since risk aversion encourages many an academic to be obscurely indeterminate, a temptation he nobly resists.

Lars Christensen tells me that George Selgin may nowadays object to being called an Austrian; that would account for much.

36 Comments

  1. TerjeP
    Posted April 24, 2012 at 6:35 pm | Permalink

    Can’t a severe widespread drought lead to an economic downturn in an economy dominated by agriculture? And if so how is this a monetary phenomenon?

  2. Posted April 24, 2012 at 7:17 pm | Permalink

    You say … “For example, it was the deflationary policies of the Federal Reserve and the Bank of France that caused the 1929-32 Depression not some mythic inflationary boom … on all these occasions, the sin being the under-provision of money by monopoly providers, not its over-provision.”

    The root cause of the crisis is the existence, in the first place, of the central bank, combined with legal tender laws and fractional reserve. The central bank institutionalizes moral hazard. It is one giant distortion. Arguing about whether it should inflate or contract, is like arguing what form of statism works best. Marxism? Nazism? Leninism? Trotskyism?

    Saying under-provision of money caused the crises, means legitimising the baseline existence of the bank in the first place. The sin is not the so-called “under-provision” of liquidity … the sin is the existence of an organisation that has the ability to “provide money” at all.

    Lets say someone has an immunodeficiency of genetic origin. The very existence of this illness changes the person’s behaviour, and further, the person must take antibiotics daily to survive. The antibiotics though, are toxic, hence the doctor, one day advises the patient to reduce their dose. This causes the patient to get an infection and become ill.

    Is the problem here that the central planning doctor made a decision to decrease the dose, rather than increase, or retain the status quo? Or is the problem the genetic immunodeficiency?

  3. Posted April 24, 2012 at 7:43 pm | Permalink

    [email protected]: Yes, there will be a fall in output but, if it were a barter economy, there would not be an excess of goods and services. It takes a monetary economy to produce a “general glut” in the old language.

    Note, the claim is not that supply shocks cannot exist, it is that a failure of the monetary authority to respond appropriately/the capacity to hoard money that leads to the excess of goods and services.

    Australia has dealt with drought, dramatic drops in commodity prices, Asian economic crises and global downturns without having a recession since 1991 because the Reserve Bank has managed monetary policy successfully.

    [email protected]: I am not arguing for (or against) central banks, I am arguing against the idea that they either err in only one direction, or it is the only direction that any errors “really counts”.

  4. kvd
    Posted April 25, 2012 at 2:55 pm | Permalink

    Lorenzo very interesting post – thanks. I particularly like your “while monetary policy can certainly be incompetent, it is never impotent” comment.

    Do you know if these economists ever take into account such things as organised crime being recently estimated as a top 20 economy or – in talking about money as a good or as a means of exchange – that global forex turnover is $US3 trillion daily in their theories?

    It just seems to me that with the development of both derivatives and currency trading the economists are basically agruing the toss over maybe 2% of the total monetary activity occurring every day, all the 24 hours of the day.

    I’m thinking there’s probably a hotshot 22 year old sitting in a Westpac basement somewhere, trading the money equivalent of Australia’s GNP every week or so. He hasn’t even paid off his first Porsche yet, so will he be guided by the heterogeneity of capital, or your basic animal spirits, would you think?

  5. TerjeP
    Posted April 25, 2012 at 4:28 pm | Permalink

    Lorenzo – so an agrarian monetary economy suffers a widespread drought and you’re concerned wth a glut? That sounds like a quite unlikely scenario.

  6. Posted April 25, 2012 at 6:20 pm | Permalink

    [email protected] Glad you liked it. Money which mainly interacts with other money has some role in risk-management and exchange rates, and generating outrageous salaries that gets folk upset over growing inequality, otherwise it is not so important.

    As for crime, that’s just supply and demand. In the raw, so to speak.

    [email protected] If you want to pursue this issue, hit the link to Nick Rowe’s argument. (Brad DeLong’s post on macroeconomics is also useful.)

    A recession is when incomes fall so lots of goods and services don’t get sold (that’s the “general glut”) so output falls, businesses close, folk lose their jobs …

    If you have a monetary economy, folk can hold on to money they have earned previously and not spend it.

    In a barter economy, “Say’s Law” actually applies. So, you have a downturn without a recession in the sense we understand them.

    Australia has not had a recession since 1991 since, when we get supply or demand shocks that might cause a recession, the RBA counteracts by loosening monetary policy, keeping nominal incomes up and, what is more, people expect it to do that, so you do not get any “flight to safety” and collapses in monetary velocity.

    Since the RBA has an “average over the business cycle” target, it is not committed to having the money supply follow output down. To put it another way, it effectively has a (growth in) price and in output target.

    As I point out above, the problem with a lot of “Austrians” is that they obsess over what is happening to prices and apparently don’t give a damn about output (and especially not unemployment).

    And don’t get me started on that “it’s structural!” crap: as Ben Bernanke pointed out recently:

    “The fact that labor demand appears weak in most industries and locations is suggestive of a general shortfall of aggregate demand rather than a worsening mismatch of skills and jobs.” … [the data] “do not support the view that structural factors are a major cause of the increase in unemployment during the most recent recession.”

    Indeed.

  7. Posted April 25, 2012 at 9:24 pm | Permalink

    I do wonder if the Austrian concept of malinvestment received added impetus from Peter Schiff being spectacularly right about the GFC while (nearly) everyone else was spectacularly wrong. I put this post up featuring him at the time:

    http://skepticlawyer.com.au/2008/12/21/i-do-not-want-what-i-have-not-got/

  8. TerjeP
    Posted April 25, 2012 at 9:27 pm | Permalink

    Output can fall for lots of reasons. My comment was merely in response to what I saw as a false generalisation about recessions always being monetary events. I don’t think that generalisation is true. A recession or contraction is simply a decline in product brought to market. That can occur for non monetary reasons. And it can persist in spite of monetary manoeuvres. A predominantly agrarian economy in a severe drought can’t lift output, or reverse a drought induced decline in output by simply fiddling with the money supply. Maybe fiddling with the money supply has merit in other situations but it is not a general solution to an exogenous supply shock.

  9. TerjeP
    Posted April 25, 2012 at 9:29 pm | Permalink

    p.s. I do agree that deflation is general a bigger problem, should it occur, than inflation.

  10. Posted April 25, 2012 at 9:49 pm | Permalink

    [email protected] I don’t know about any specific Peter Schiff effect, but I am sure the GFC followed by the Great Recession gave impetus to Austrian notions. The Wall St Journal is channelling Rothbard and the Ron Paul candidacy gets significant impetus from Austrian economics.

    [email protected]

    A recession or contraction is simply a decline in product brought to market.

    What about a negative demand shock?

    but it is not a general solution to an exogenous supply shock

    Isn’t that precisely what the RBA managed when commodity prices plunged by 50% and our exports dropped (albeit temporarily) dramatically (by as much as the US’s did, as a share of GDP, btw)?

    The suggestion is not that one “magically” lifts output, it is that the effect is cushioned. Or not, depending on how your monetary policy works.

  11. John Turner
    Posted April 26, 2012 at 7:25 am | Permalink

    Too often in economics people are too busy looking at the trees. Economics is one area where Occam’s Razor should be used as often as possible.
    One example is free banking. That was tried for years before central banking and led to diabolical bank collapses. I prefer the comment of the late USA comedian Will Rogers, “There have been three great inventions since the beginning of time: Fire, The Wheel and Central Banking.”
    That has to be balanced of course by Alfred Marshall’s “Every short statement about economics is misleading (with the possible exception of my present one.)”

  12. .
    Posted April 26, 2012 at 9:11 am | Permalink

    Too often in economics people are too busy looking at the trees. Economics is one area where Occam’s Razor should be used as often as possible.
    One example is free banking. That was tried for years before central banking and led to diabolical bank collapses

    No. That is not true. Please read Selgin and White, and Mises (Human Action Ch 17). Briones and Rockoff is a good starting point as well.

  13. .
    Posted April 26, 2012 at 9:17 am | Permalink

    I’ll also add John that you’re either very clever or have missed the point that Rogers was making a joke at the expense of central banking.

    Central banking has resulted in a multitude of failures, both in banks and the general economy.

    The issue of contention for those who support central banking is supply of currency – they have no beef with banks issuing credit.

    Do they know how banks work? A bank cannot issue too much currency or it will change the asset liability management of their balance sheet to the extent where it can wipe them out.

    Remember, society chose gold by convention. Fiat has created more worthless notes than free banking ever will. Governments have repudiated gold as a cheap and underhanded method of finance.

  14. Mel
    Posted April 26, 2012 at 10:08 am | Permalink

    [email protected]:

    “I do wonder if the Austrian concept of malinvestment received added impetus from Peter Schiff being spectacularly right about the GFC while …”

    Sigh. The list of economists who were “spectacularly right” about the GFC now numbers in the thousands although each of them has a mutually exclusive theory that led them to their spectacular conclusions ….

    A quick google shows Schiff has predicted US hyperinflation and all manner of other “we’ll all be rooned” catastrophes since Obama came to office. God knows why you’ve chosen to elevate this particular lunatic above the pack.

    You also appear to have completely misunderstood the GFC. This paper is a useful prophylactic against the tommy rot put out by the Daily Tellie, the Wall Street Journal etc

    But of course the above is just my opinion and I may well be wrong 🙂

  15. Mel
    Posted April 26, 2012 at 11:54 am | Permalink

    To continue, SL has picked up on one the the Big Lies told by certain right elements about the GFC, namely that the CRA was a major causal factor. From the above report:

    “The claim that the Community Reinvestment Act caused the financial crisis is not supported by empirical evidence. In his FCIC dissenting opinion, the only data Wallison [right wing think tank hack] provides to support this hypothesis is a table showing annual and cumulative dollar volumes of low-income lending to which financial institutions committed from 1977 to 2007.146 This table not only fails to establish causation; it fails to even establish a connection between commitments under the CRA and actual lending activity. Wallison acknowledged that lenders appear to have frequently failed to fulfill their commitments and that the available data makes it “impossible to determine how many loans were actually made under . . . CRA commitments . . . .” Furthermore, according to Wallison, even “[w]here these loans are today must remain a matter of speculation.” The handful of academic articles suggesting that the CRA might have caused the financial crisis also do not present empirical evidence to support this claim. There is, however, substantial empirical evidence that the Community Reinvestment Act was not a significant cause of the financial crisis. Empirical studies by two different teams of Federal Reserve economists both suggest that CRA lending accounted for a minority of subprime lending, and that CRA loans performed better than subprime loans that were driven purely by market considerations.”

    In Australia, the usual hacks like Chris Iceberg-Lettuce from the IPA have promulgated the Big Lie. Of course, the Catallaxy hacks have also jumped on the bandwagon.

  16. Posted April 26, 2012 at 12:54 pm | Permalink

    [email protected] A failed prediction of hyperinflation, he would be an Austrian economist then.

    The CRA does not seem to have been a big player. Fannie Mae and Freddie Mac, however …

    A guilty party folk do not often pick up on is the IMF. Its policy of “welfare for Wall St” has injected huge amounts of moral hazard into global financial systems. It was bound to end up biting the developed economies eventually.

    But there is a lot of blame to go around.

  17. Mel
    Posted April 26, 2012 at 2:04 pm | Permalink

    Freddie and Fannie were at most a sideshow. Again from the above report:

    “From 2001 to 2008, the GSEs purchased approximately 30 percent of subprime private label MBS and approximately 10 percent of Alt-A private label MBS. GSE purchases grew from 2001 to 2004, and then declined from 2004 to 2008. As previously noted, the worst performing loans were originated in 2004 to 2007. In 2004 to 2007, subprime and Alt-A private label MBS volume increased, meaning that many other investors stepped up their purchase activity at the worst possible time, providing funding as the GSEs withdrew.

    Although the GSEs reduced their purchase activity as the quality of the underlying collateral deteriorated, their policy shift may have had less to do with investment acumen than with regulatory pressure following an accounting scandal. Notwithstanding their portfolio losses, overall GSE
    loan delinquency rates are still substantially below those of most other market participants

  18. Posted April 26, 2012 at 2:45 pm | Permalink

    Well, that’s the thing with Schiff and Keen (a neo Keynesian). One has to work out whether they were right because of unusual powers of insight, or right in the same way that a stopped clock is right twice a day.

    Doing this can be difficult 😉

  19. Posted April 26, 2012 at 3:14 pm | Permalink

    [email protected] There is a difference between rates and levels. Also, bailing out the GSE’s looks set to cost the US taxpayer quite a lot more than TARP.

    The paper was informative, but not entirely convincing (see previous para). A major reason why the financial sector in the US is so fragmented is government regulation keeps it that way (not the on-again, off-agin, on-again bars on separating investment and deposit banks–a separation I have no particular problem with–but the limits on interstate branching).

    Also, when the author asserted that government agencies are rationally risk averse I thought Tricontinental, State Bank of SA.

    Sensible prudential regulation and permitting interstate branching seems a rather better way to go than a government mortgage agency. (One of the issues with the GSE’s is that they ended up having a lot of clout in Congress.)

  20. Posted April 26, 2012 at 3:16 pm | Permalink

    If folk want to see an example of an internet Austrian defining away evidence, etc, try this.

  21. kvd
    Posted April 26, 2012 at 3:19 pm | Permalink

    [email protected], are you sure you know what you’re talking about? I took your referenced paper to be pointing out the negative effects on the previously quite conservative lending practices of the two F’s caused by the aggressive tactics of several non government guarenteed ‘players’ in the market.

    I think it says that in order to ‘compete’ the F’s lowered their standards? Which might be fine, except they did so with the moral hazard of a full government insurance policy.

    So, the mini-me’s collapsed without government support, and the larger players passed on their losses to their supporter – the taxpayer.

    The question really is: how significant is it if a bit player loses his $5 in the poker game, compared to a major player degrading the security risk of a significant percentage of his funds? And you’re talking about the F’s which controlled 80-90% of the mortgage market; now over 95%.

    The paper is very interesting, but I’m not sure it is aimed at what you are seeking to prove.

  22. Posted April 26, 2012 at 3:27 pm | Permalink

    What is remarkable is his astonishingly primitive conception of legal authority (the endless ‘all law is coercive point’). That’s straight of Austin’s ‘command theory’. It has been definitively rebutted, and is taught in law schools as an historical curiosity only.

  23. TerjeP
    Posted April 26, 2012 at 3:34 pm | Permalink

    What about a negative demand shock?

    That may be a causal factor in some instances but it does not span the breadth of the problem. There are many reasons output can fall and a lack of buyers is but one.

  24. Mel
    Posted April 26, 2012 at 3:42 pm | Permalink

    Small potatoes.

    “The cost to taxpayers for bailing out mortgage finance giants Fannie Mae and Freddie Mac won’t be quite as bad as previous estimates, according to the federal agency overseeing the two companies.
    The Federal Housing Finance Agency now estimates that the net cost of the bailouts through 2014 will be about $124 billion, down about 19% from an estimate of $154 billion a year ago.”

    Most importantly, from the above figure you need to subtract the cost to the Fed Gov’s bottom line had the Freddie and Fannie loans been made by the private sector, which is what would have happened if F/F did not exist.

    All in all, the cost of F/F failure is a minor sideshow.

    Indeed, compared to this fiasco, which you support, it is a pimple on an elephant’s bum.

  25. kvd
    Posted April 26, 2012 at 4:19 pm | Permalink

    Mel: 1+1=3
    Response: Possibly not
    Mel: Look over here! A grasshopper!

  26. Mel
    Posted April 26, 2012 at 7:49 pm | Permalink

    What are you babbling about kvd? Freddie and Fannie accounted for only a small portion of subprime loans that went bust. Do learn to read, think and comprehend before spilling ink, dear thing.

  27. kvd
    Posted April 27, 2012 at 4:20 am | Permalink

    [email protected] as far as I can tell, there was no one, single, cause of the financial crisis. The paper you referenced @14 analyses the factors which may have influenced the contribution of the F’s to the whole sorry saga. To quote your own reference:

    Scholars, government commissions, and others have identified many possible causes of the financial crisis of the late 2000s.(*below) This article focuses primarily on competitive dynamics and also discusses a limited subset of other possible contributing causes. The focused analysis in this article is not meant to deny other contributing causes, but rather to highlight factors that have not been adequately discussed in the literature and whose implications have been overlooked by leading proposals for market reform.

    (*) These include, but are not limited to, conflicts of interest at credit rating agencies and overly optimistic credit ratings for mortgage backed securities (“MBS”); ample liquidity, low interest rates, and investors reaching for higher yields; moral hazard and information inefficiencies related to securitization; conflicts of interest and information inefficiencies related to financial innovations such as collateralized debt obligations;
    limited liability, high leverage, and financial executives incentivized to take big risks; fragmented and light-touch regulation; and possibly affordable housing policies.

    Mel, I can’t actually see anything in there about the “fiasco” you now claim as the primary cause. As I said – “look! Over here!”

  28. Posted April 27, 2012 at 4:31 am | Permalink

    [email protected]

    There are many reasons output can fall and a lack of buyers is but one.

    Obviously, and nothing I said denies that for a second.

    [email protected] I gather the reference to the wars in Iraq and Afghanistan is a standard reference to irrelevant matters to maintain status.

    [email protected]

    Freddie and Fannie accounted for only a small portion of subprime loans that went bust.

    Rates and levels: their delinquency rate might have been lower but they had such a big share of the market that they had a very substantial proportion of the bad loans, hence the “conservatorship”.

  29. Posted April 27, 2012 at 4:44 am | Permalink

    Yes, for the avoidance of any doubt, I opposed the war in Iraq and was ambivalent about Afghanistan. Many libertarians and classical liberals (Ron Paul being the easiest example in context) opposed both.

    I am an empiricist with a strong utilitarian streak (unlike Paul); I don’t think there are per se rights or bulletproof arguments for or against war. I do think it ought to be treated with very great caution, however, mainly because it’s expensive and often doesn’t work…

  30. Mel
    Posted April 27, 2012 at 7:56 am | Permalink

    Umm, Lorenzo, as we’ve discussed before, even the Republican FCIC Commissioners (right wing think tank kook Wallison excepted) dismissed the idea that the GSEs were significant causal players in the GFC.

    Wallison’s argument has been refuted many times including here.

    By repeating this absurd talking point you’ve merely demonstrated that you are only a bee’s knee away from the Gold Standard-Hyperinflation Austrian rah-rah gals. Clearly you’ve allowed ideology to trump reason on this matter like so many others

    ps. contrary to Jo Nova’s latest rant, James Hansen is not a lizard man from the planet Orb 😉

  31. Posted April 27, 2012 at 2:59 pm | Permalink

    [email protected] I am not blaming the GSEs for the GFC, that would be absurd, given the GFC was bigger than the US mortgage market. (And even if one accepted the argument that Wall St accepted higher levels of risk to compete with the GSEs, that was hardly the GSEs’ fault.) I was expressing scepticism that some derivation of the GSEs provided some good way forward.

    The destruction of prudence was much bigger than even the US housing market.

  32. Mel
    Posted April 27, 2012 at 5:23 pm | Permalink

    Thanks Lorenzo.

    Certainly the GSE setup was foolish and the corrupt “money power” nature of American politics means any reform is likely to be suboptimal.

  33. Posted April 28, 2012 at 11:19 am | Permalink

    [email protected] Always happy to clarify 🙂

    On which point, Daniel Kuehn has an excellent post on policies and goals, illustrating different views of Market Monetarists and Keynesians.

  34. Posted May 5, 2012 at 8:05 pm | Permalink

    [email protected] Bill Woolsey considers the case of a cotton blight when cotton is 10% of GDP here (so essentially your case),

  35. Reinhard
    Posted May 10, 2012 at 4:28 pm | Permalink

    Hey Lorenzo, by far the most interesting and insightful critique of Austrian theories I have seen.

    I’d like to add my own thinking about some of your points.

    1,2,3) If a lot of capital goods turned out to be in the wrong use at the same time then a large investment in labour would be required to convert them. Capital conversion is thus a natural part of the economy but would spike at certain times – namely some time during a recession. The same applies to labour itself because retraining takes time of course, and when a person studies he is investing intellectually in that career path.

    4,5) Any unnatural change in the money supply will cause a shock, it is just that those shocks are of a different kind. Gradually falling prices are no problem if the money supply is not contracting in a sudden unnatural way. Austrians, I think rightly, blame the fact that such a deflation shock can occur at all on the prior inflation. Once the money supply has been unnaturally (through fiat inflation, FRB expansion, take your pick) increased price stability becomes impossible, because as that additional money filters through the economy and increases the price level the only way to put a halt to that price increase is to actually reduce the money supply. The severity of this will be decided by what level of inflation is considered acceptable. Thus I think that it is the central bank’s desire to prevent the price inflation that causes much of the “downside” problem. It would be a much better policy to refuse to change the supply in any way and allow prices to stabilise at a higher level.

    6,7,8) I think it is reasonable to say that Austrians discount risk in the interest rate issue. The question then becomes, is it that lower interest rates will decrease savings because of poor returns or increase them because of lower perceived risk? I think this is at the core of what causes the business cycle, because low interest rates will cause low yield investments to become more populous while at the saver end the average man will save less because the perceived risk in a bank is usually close to 0, and thus the interest rate is very much a supply/demand. Personally I think that at very low interest rates (less than 3%) the savings rate is inelastic because those savings are prudential rather than an investment.
    So if we assume that time preference is the wrong way to look at it and we instead consider risk perception, we need to understand why perception changes suddenly. I believe that the injection of cash into the investment sector will gradually cause the prices of capital goods to rise and at some tipping point it will become evident that some enterprises will not be profitable under the current price levels and expected future prices (for capital goods). These higher prices will thus conceivably cause a crash in the demand for capital goods as the contageon spreads. The demand crash causes unemployment from those unprofitable companies, causing a demand crash in the consumer goods sector as well, further exascerbating the unemployment problems.
    As a result of these demand crashes only the highly profitable producer companies will be able to keep trading. From their perspective it is better if the money supply remains constant because then the price inflation will allow them to pay off their creditors through higher numerical revenue despite decreased sales. If the central bank elects to focus on inflation and raises interest rates these companies will face reduced revenue and higher interest rates, likely making many of them insolvent as well. I believe this is a very plausible explanation for the Great Depression, since we know deflation occurred. In a sense the motivations for deflation are immaterial – it will cause a bust proportionate to the deflation. The magnitude of the impact of the previous inflation is then a function of how far deflation is allowed to continue – if it goes to the money supply before the boom then it will be as mild as the boom, if allowed or forced all the way down to the monetary base then you could have a truly catastrophic contraction unless the boom started when the money supply was already at the monetary base.
    The Austrians do have the cause of producer goods price rises correct, I believe: that low interest rates cause real savings to be lower than real investment, thereby eventually causing increased competition between consumers and producers for raw materials.
    So to summarise: deflation is bad because it causes naturally profitable enterprises to go bust, inflation is bad because it causes naturally unprofitable enterprises to be started. There’s a pleasing symmetry there, isn’t there?

    10,11,12) I agree with most of what you said here. Under my construction the idea of a malinvestment is in a sense not there. The investments are all profitable when investment is high and prices are still low. So it’s not that the entrepreneurs make a mistake at the time given the conditions, it’s that later price increases are unforseen and reveal those investments as unprofitable. The difference, in real terms, between a profitable and unprofitable enterprise is that the former uses fewer real goods than are given up by people when they save, and the latter uses more. The problem with a boom is that it reduces the real resources available to those enterprises on the margin and makes many otherwise profitable ventures fail when the bust comes.

    Any way you cut it some companies will have to fail. There are only three options: Deflation, which destroys profitable companies; constant money, which I believe is the cure; and inflation which, in order to prevent the failure of those companies that used real resources not “saved” by consumers would have to constantly increase until the result was hyperinflation. That’s the only way to get the necessary “forced saving” and hyperinflation will be inevitable as people realise their money is losing value, since by definition they will be forced to give up more real goods than they actually want to.

  36. Posted May 22, 2012 at 3:28 pm | Permalink

    Scott Sumner has an excellent discussion of Austrian and Modern Monetary Theories (MMT) here.

2 Trackbacks

  1. […] as a serious and fair-minded critic of Austrian economics.  His long post of April 24th [posted at Skepticlawyer on the same day] raises a whole host of important issues, all of which I would like to respond […]

  2. […] Horwitz’s thoughtful and generous response to my original post is useful in clarifying what a serious Austrian school economist thinks and correcting some of my […]

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